The economy is GREAT!...if you don't count inflation

Let's say one month you spend $100 on groceries. The next month you spend $120 for the exact same groceries. According to the government we all became richer because you are spending more for the exact same stuff.

Durable goods orders beat expectations with a 1.3% month-on-month increase in July. But the apparent strength is due to higher prices, not stronger activity. In fact, deflating orders by the producer price index for durable manufactured goods shows a 9.4% year-on-year drop in real orders, the worst since early 2002.

Am I picking out one little report to try and make a big point? Nope. Allow me to dig through pretty much every single economic report the government releases.

The durable orders report I listed above is for manufacturers. Retail sales is for consumers.

While retail sales rose 2% on a year/year basis, after adjusting for inflation, sales actually declined by 1.9%. In fact, this month's decline marks the fifth straight monthly year/year decline. This is the longest streak of monthly declines in the last fifteen years.

Of course the really BIG numbers are the GDP numbers, and as you can imagine, they've been spun to the point that they don't reflect reality at all.

Part of the reason the GDP number looked so good was because the GDP price index for the second quarter was marked at just 1.2. In other words, BEA subtracted from nominal GDP 1.2% in order to produce their version of "real" (inflation-adjusted) GDP.The GDP Price index is even lower than the already laughable CPI inflation index.

The CPI was 0.2% in April, 0.6% in May, and 1.1% in June. The average for Q2 is about 0.6%, which comes out to an annualized rate of about 7%. So how do you come up with 1.2% out of that? Obviously you make up the numbers.

When the Q4 2007 GDP growth was revised from +0.6% to -0.2%, half of that was due to the deflator being revised upwards from 2.44% to 2.84%. In Q1 2008, the revised inflation figure was 2.63%. So we're in a world of inflation somewhere between 2.5% and 3.0%? Not according to the Q2 2008 deflator, which was a very low 1.06%.

If inflation was running at a 2.5% pace in Q2, then growth would come down to just 0.5%.

A real inflation rate of 2.5% would be wonderful. Not only would it knock the GDP down to almost nothing, it would still only be about half of what the CPI was during the past quarter.
From June 2007 to June 2008 the CPI ran at a 5.6% rate, which makes the act of using a GDP deflator of 2.5% a bad joke.

"It is hurting Fed credibility to say that we are trying to keep inflation low and stable, but at the same time we are not counting some of the prices that are going up at the most rapid pace," Bullard wrote in the bank's magazine, "The Regional Economist."

What does he mean by that? A good example was the CPI of only 0.2% in April. How was consumer inflation so low that month?

Since gasoline prices normally rise significantly in April, the 5.6 percent rise in prices for the month turned into a 2 percent drop after the government adjusted for normal seasonal changes. That was little comfort for motorists now paying record prices at the pump, which are nearing $4 per gallon.

Let me reacquaint you with the debate about the authenticity of U.S. inflation calculations by presenting two ten-year graphs – one showing the ups and downs of year-over-year price changes for 24 representative foreign countries, and the other, the same time period for the U.S.
These representative countries, chosen and graphed by Ed Hyman and ISI, have averaged nearly 7% inflation for the past decade, while the U.S. has measured 2.6%. The most recent 12 months produces that same 7% number for the world but a closer 4% in the U.S.
This, dear reader, looks a mite suspicious. Sure, inflation was legitimately much higher in selected hot spots such as Brazil and Vietnam in the late 90s and the U.S. productivity “miracle” may have helped reduce ours a touch compared to some of the rest, but the U.S. dollar over the same period has declined by 30% against a currency basket of its major competitors which should have had an opposite effect, everything else being equal. I ask you: does it make sense that we have a 3% – 4% lower rate of inflation than the rest of the world? Can economists really explain this with their contorted Phillips curve, output gap, multifactor productivity theorizing in an increasingly globalized “one price fits all” commodity driven global economy? I suspect not.

The reason for this massive, and inexplicable difference in inflation rates can be attributed to decisions made by our elected officials.

The U.S. seems to differ from the rest of the world in how it computes its inflation rate in three primary ways: 1) hedonic quality adjustments, 2) calculations of housing costs via owners’ equivalent rent, and 3) geometric weighting/product substitution. The changes in all three areas have favored lower U.S. inflation and have taken place over the past 25 years, the first occurring in 1983 with the BLS decision to modify the cost of housing. It was claimed that a measure based on what an owner might get for renting his house would more accurately reflect the real world – a dubious assumption belied by the experience of the past 10 years during which the average cost of homes has appreciated at 3x the annual pace of the substituted owners’ equivalent rent (OER), and which would have raised the total CPI by approximately 1% annually if the switch had not been made.

In the 1990s the U.S. CPI was subjected to three additional changes that have not been adopted to the same degree (or at all) by other countries, each of which resulted in downward adjustments to our annual inflation rate. Product substitution and geometric weighting both presumed that more expensive goods and services would be used less and substituted with their less costly alternatives: more hamburger/less filet mignon when beef prices were rising, for example. In turn, hedonic quality adjustments accelerated in the late 1990s paving the way for huge price declines in the cost of computers and other durables. As your new model MAC or PC was going up in price by a hundred bucks or so, it was actually going down according to CPI calculations because it was twice as powerful. Hmmmmm? Bet your wallet didn’t really feel as good as the BLS did.